Who Rules Accounting?

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Dennis Beresford is having flashbacks these days, and they are anything but pleasant. Congress is once again trying to derail the Financial Accounting Standards Board’s efforts to require companies to expense stock options. And for the former FASB chairman, the lawmakers’ moves are a painful reminder of what happened during his tenure at the board’s helm nearly a decade ago. “It’s déjà vu all over again,” says Beresford, now a professor of accounting at the University of Georgia.

Under intense pressure from Capitol Hill, FASB under Beresford backed off of a similar proposal in 1994, compromising not only the board’s position on expensing but its very independence as a standard setter. It took years for the board to buck congressional pressure again, this time on new, far-reaching rules on derivatives and business combinations. Of course, FASB’s submission to Congress did nothing to prevent lawmakers from scolding the board for the cautious pace of its its deliberations on accounting issues related to the Enron scandal.

No one in Washington, D.C., claims to desire an end to the independent setting of accounting rules, at least in public. The legislators insist they are merely trying to aid the struggling economy by encouraging greater use of entrepreneurial incentives.

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But will keeping stock options off the income statement have the desired effect? Many observers contend that while FASB’s 1994 decision not to require options expensing may have inspired entrepreneurs, it also certainly motivated executives to pump up their companies’ stock prices by whatever means necessary. In fact, the widespread use of nonexpensed stock options is generally thought to have led not to economic strength, but to inflated stock-market valuations, excessive executive compensation, accounting frauds, bankruptcies, and the loss of approximately $5 trillion.

Some managers may welcome congressional efforts to reinflate the stock- market bubble, but forcing FASB to back down on options could instead undermine whatever confidence in the financial markets investors have since regained. “The capital markets need high-quality, unbiased information to make allocation and pricing decisions,” says FASB board member G. Michael Crooch. “Managing accounting data for some hoped-for economic result is too risky and dangerous.”

A Simple Bill

The current fight is still in its early stages. Until recently, in fact, the latest debate over expensing was limited to arcane issues involving valuation methodology. But now Congress has reentered the picture, and its legislative steps would render the outcome of the debate about valuation methods all but moot.

At first glance, the bill introduced in March by Rep. David Dreier (R-Calif.) and co-sponsored by Rep. Anna G. Eshoo (D-Calif.) — H.R. 1372, or the Broad-based Stock Option Plan Transparency Act of 2003 — sounds innocuous enough, calling as it does for enhanced disclosure of stock-option plans.

But the bill, which has attracted considerable bipartisan support, including that of half the Democratic presidential hopefuls, first demands a three-year study by the Securities and Exchange Commission to assess the potential impact of broad-based stock-option plans on the economy.

Meanwhile, the legislation would impose a moratorium on new FASB rules related to stock options, so if the board went ahead and mandated expensing anyway, the SEC would be barred from recognizing the rule as part of generally accepted accounting principles (GAAP).

So much for independently set accounting standards.

Back to the Future

In the face of similar pressure nine years ago, FASB’s retreat enabled it to live to fight another day. But board members and others involved in that decision now regret the move. Former SEC chairman Arthur Levitt admits that urging FASB to back off was “the biggest mistake I made” during his eight-year tenure.

The International Accounting Standards Board (IASB), FASB’s international counterpart, is clearly concerned about the impact the bill could have on accounting standards in general. “If the U.S. Congress or political authorities in other countries seek to override the decisions of the competent professional standard setters…accounting standards will inevitably lose consistency, coherence, and credibility,” warned Paul A. Volcker, former Federal Reserve Board chairman and current chairman of the foundation that oversees the IASB, in written testimony.

But Eshoo and Dreier represent districts in California where incentive stock options are still sacrosanct. And to be sure, high-tech companies, many in their early stages and strapped for cash, rely on stock options as incentives for employees as well as for executives. According to these lawmakers, expensing would hobble the ability of such start-ups to attract talent and, in turn, stifle innovation in the U.S. economy. “This is a public-policy issue,” said Dreier in his testimony at the hearing in June. “This is not an accounting issue.”

Yet it’s hard to see how accounting is not public policy when the public relies on financial statements prepared under U.S. GAAP to determine whether companies deserve its capital. In FASB’s view, options should be included in the income statement like other forms of compensation expense, because that would give shareholders a more honest picture of a company’s finances than burying the impact of options in the footnotes. Investors applaud the stance. “If the result of having [option-based pay] expensed means you do away with the plans,” says Peter Clapman, senior vice president and chief counsel of corporate governance at TIAA-CREF, “it means that it was never a particularly good form of compensation in the first place, because it shouldn’t depend on accounting treatment.”

The IASB, for its part, agrees with FASB. And there’s nearly universal agreement that the capital markets would benefit from a single global standard for financial reporting on this item as well as others.

Of course, it’s not surprising that FASB’s congressional opponents claim their legislation does nothing to compromise FASB, which was established in 1973 as a replacement for the American Institute of Certified Public Accountants’s Accounting Principles Board.

With a board of seven paid, full-time members intended to keep standard setting a function of the private sector, FASB’s structure is supposed to ensure its independence from private interests that might interfere with its primary objective of creating neutral accounting rules. And while the Securities Exchange Act of 1934 gives the SEC the authority to set standards, the commission delegates that authority to FASB.

Lest Congress forget these facts, current FASB chairman Robert H. Herz reminded members during a recent House subcommittee hearing on H.R. 1372. “The moratorium,” he proclaimed, would likely establish a “potentially dangerous precedent” and “signal that Congress is willing to intervene in the independent, objective, and open accounting standard-setting process based on factors other than the pursuit of sound and fair financial reporting.” Herz also noted that such interference would be “inconsistent with the language and intent” of the Sarbanes-Oxley Act of 2002, which includes added measures to ensure FASB’s independence. He warned Congress that unlike his predecessors, he’s “not gun-shy” about promulgating that view.

But Herz’s warnings fell on deaf ears. Eshoo agrees that Congress “should not get into writing accounting standards” and that “FASB should be able to retain its independence.” How exactly can that circle be legislatively squared? “If we are prevented from issuing what we consider to be a better and high-quality standard,” notes FASB’s Crooch, “that’s not very far from setting a standard.”

Damned Economy

Dreier and Eshoo, however, adamantly defend their efforts. “I’m not doing anything that’s counter to my constitutional obligations,” Dreier insists. Eshoo says much the same thing. “I wish there were a meeting of the minds [with FASB],” she says, “but if there isn’t, then I believe that it is absolutely appropriate. It is not interference, it is Congress exercising its responsibility relative to our nation’s economy.” She adds: “FASB has not been willing to examine anything except expensing, and economic issues be damned. I think we can do better than this.”

But there’s reason to believe that Dreier and Eshoo are mistaken about the need to restrain the board to help the economy. Consider Netflix, an online DVD rental service that went public in May 2002 and announced this past June that it would expense options. Expensing, says CFO Barry McCarthy, provides the company with “consistency in financial reporting.” And he doesn’t expect the decision to have a negative impact on his ability to raise new capital. “In my experience,” he says, “investors increasingly distinguish between accrued expenses and real cash expenses.”

What’s more, McCarthy suggests lawmakers are being disingenuous about the intended beneficxiaries of the legislation. “Whenever you have large public companies that think their ox is going to be gored by a change in accounting principles,” he says, “there’s going to be a battle about the outcome.”

Battle-hardened FASB members aren’t taken aback by what’s happening. “Standard setting is not a popularity contest and shouldn’t be a popularity contest,” notes Jim Leisenring, who was vice chairman of FASB during the earlier debate over expensing, and one of the two members who did not succumb to congressional pressure in the final vote. Leisenring, now a member of the IASB, says, “I believe FASB made a mistake in backing down, but they did so in the context of having no support from anyone.”

A Delaying Tactic

How will the new battle turn out? Because of the dangers posed by the proposal in Congress, some observers predict it won’t get very far. “I don’t believe in the face of continuing revelations of accounting misdeeds that Congress is likely to destroy the standard-setting process,” says Levitt. “It’s just a delaying tactic.”

Levitt isn’t alone in dismissing the threat. TIAA-CREF’s Clapman believes some lawmakers who may have been comfortable 10 years ago openly favoring the high-tech-industry position on options are reluctant to do so today. “A congressman or -woman who looks at this knows that their position is being scrutinized in ways that were not the case back in 1993,” he says.

What’s more, big accounting firms like Ernst & Young and shareholder lobbyists like the Council of Institutional Investors have reversed their opposition to expensing, while nearly 300 public companies, including Microsoft, have adopted it during the past 18 months in anticipation of a change in the rules. While Microsoft recently abandoned new options grants in favor of restricted stock, the technology bellwether has also decided to expense options already granted.

The SEC has historically supported FASB’s decisions, and chairman William H. Donaldson is on record as favoring the board’s efforts to expense options. FASB “has put itself on the line and said there’s an expense attached to stock options,” Donaldson told the Economic Club of New York in May. “I am waiting restlessly for this to happen.” But will Donaldson stick to that position under pressure from Congress or the White House?

With enough political support for the bill, Eshoo predicts that the head of the SEC would find it difficult not to go along. “Certainly, chairman Levitt did,” she observes. Levitt himself thinks Donaldson will stick to his guns. “We have an SEC chairman that is solidly behind the expensing proposal,” he says.

To be sure, Donaldson also said publicly that he plans to visit with executives in California who oppose expensing options. “I am willing to listen,” he said in May. But he told them not to get their hopes up. “As far as I’m concerned,” he warned, “we have crossed the Rubicon.”

Perhaps. Congressional support for the bill is by no means overwhelming at this point. But Beresford fears that Sarbanes-Oxley has inadvertently made FASB more vulnerable to political pressure. Previously, about a third of FASB’s annual budget came from voluntary contributions from public accounting firms, the AICPA, and some 1,000 individual corporations.

Under Sarbanes-Oxley, those voluntary contributions are replaced by mandatory fees from all publicly owned corporations based on their individual market capital-ization. But the fees are to be collected by the newly formed Public Company Accounting Oversight Board. And the SEC oversees the PCAOB.

While Beresford believes the new setup gives FASB more independence from the business community, he says, “it’s not clear that it has more independence from the political process. In fact, it may have less [independence] from Congress and other people in Washington.” Under the new arrangement, it’s a pretty simple matter for the SEC to pressure FASB. “The SEC could give them a hard time with their budget,” notes Beresford, “and just not get around to collecting the money they made.”

In other words, how FASB votes on options expensing may depend on how William Donaldson handles the board’s paychecks.

FASB’s Surgeons

On its own terms, the legislation now before Congress poses less of a threat to FASB’s independence than a bill introduced a decade ago.

In 1993, legislation introduced by Sen. Joe Lieberman (D-Conn.) would have not only nullified the effect of the proposed FASB standard on stock options but also effectively put the board out of business, notes then-FASB chairman Dennis Beresford.

The bill, which garnered broad support, required the Securities and Exchange Commission to redo the whole standard-setting process. Faced with its likely passage and virtually no support for its project by executives, the accounting industry, or the SEC, FASB backed away from expensing, instead requiring disclosure of the cost of options only in the footnotes of financial statements.

The Senate ultimately voted 88 to 9 for a nonbinding resolution that urged FASB not to expense stock options. “It was basically a warning shot,” says Beresford, “but the bigger concern was the actual legislation proposed by Lieberman.”

“The difference now is that they’re dealing only with the stock-options issue,” Beresford says of the bill introduced in March by Rep. David Dreier (R-Calif.) and co-sponsored by Rep. Anna G. Eshoo (D-Calif.). “It’s more of a surgical strike.”

Since a House subcommittee hearing on the bill in June, 13 representatives have joined as co-sponsors, for a total of 53 bipartisan supporters. That represents more than 12 percent of the total 435 House representatives. A companion bill, S. 979, introduced in the Senate in May by John Ensign (R-Nev.) and co-sponsored by Barbara Boxer (D-Calif.), faces a more uncertain future despite having a higher level (19 percent) of bipartisan support. Senate Banking Committee chairman Richard Shelby (R-Ala.) recently said he would deny that bill a hearing in the Senate, believing as he does that lawmakers shouldn’t be interfering in FASB’s affairs.

But as the outcome of Congress’s last battle with FASB over stock options suggests, legislation needn’t be enacted to have the desired effect. —C.S.

D.C. Versus the Board

Stock options haven’t been the only source of friction between the Financial Accounting Standards Board and its federal overseers. To be sure, the Securities and Exchange Commission has only officially overridden FASB once since the board’s inception in 1973. That decision came a few years later, as FASB was writing rules for oil and gas exploration and development costs.

Congress, for its part, has taken an interest in several other FASB projects over the years, including accounting for derivatives and the business combinations and goodwill project. The latter issue, which ultimately eliminated pooling of interests accounting, spawned legislation and arguments that are strikingly similar to those stemming from today’s options-expensing debate.

During hearings on the proposed elimination of pooling, for instance, Cisco Systems Inc. CFO Dennis Powell, then corporate controller, warned during a Senate hearing that the proposal “will certainly stifle technology development, impede capital formation, and slow job creation in this country.” He further argued that a switch to the purchase model would lead companies with a higher percentage of acquired intangible assets “to report an arbitrary, artificial net-income number that is irrelevant and misleading.”

Of course, that view assumes that investors’ perceptions are more important to economic growth than business fundamentals, and the bursting of the Internet bubble has thrown cold water on such thinking, at least for the time being. But that hasn’t prevented industry lobbyists from rehearsing the argument in the latest battle with FASB.

Yet Barry McCarthy, CFO of online DVD rental service Netflix, thinks such concerns are vastly overblown. “Our investors focus on EBITDA and free cash flow just as much as on net income and net loss in deciding what the enterprise is worth,” he says. “The conventional wisdom on Wall Street has been that investors look right through the stock-option charges for tech companies.”

According to Silicon Valley, however, they won’t if the charges are no longer buried in the footnotes. The question is, is that a good thing or a bad thing? —C.S.

The Same Old StoryThe debate over accounting for stock options is 30 years old and counting.